may 2017 rff dp 17-09 discussion paperthe cost of natural disasters has been steadily increasing...

May 2017 RFF DP 17-09

Defining the Roles of the Public and Private Sector in Risk Communication, Risk Reduction, and Risk Transfer

Car o l yn Kousky and How ard Kunreut her

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© 2017 Resources for the Future. All rights reserved. No portion of this paper may be reproduced without

permission of the authors.

Resources for the Future (RFF) is an independent, nonpartisan organization that conducts rigorous economic

research and analysis to help leaders make better decisions and craft smarter policies about natural resources and the

environment.

Discussion papers are research materials circulated by their authors for purposes of information and discussion.

They have not necessarily undergone formal peer review. Unless otherwise stated, interpretations and conclusions in

RFF publications are those of the authors. RFF does not take institutional positions.

Defining the Roles of the Public and Private Sector in Risk

Communication, Risk Reduction, and Risk Transfer

Carolyn Kousky and Howard Kunreuther

Abstract

Insurance is an essential component of household and community resilience: it protects insureds

financially against disaster losses, can encourage investments in cost-effective mitigation measures

through premium reductions, and facilitates rebuilding of property and long-term recovery following a

disaster via claim payments. Private insurers face challenges in providing protection against low-

probability, high-consequence events, however, and the perceived market failures have led governments

around the world to create various (quasi to fully) public insurance entities, often designed as public–

private partnerships. This paper synthesizes findings from six papers and the resulting discussion at a

November 2016 workshop, “Improving Disaster Financing: Evaluating Policy Interventions in Disaster

Insurance Markets.” Participants evaluated disaster insurance programs for flood, earthquake, and

terrorism losses, as well as comprehensive homeowners policies. This paper discusses the difficulties in

providing protection against these types of disasters and suggests ways to improve public-private

partnerships for disaster financing in three interrelated areas: (1) risk communication, (2) risk reduction,

and (3) risk transfer. The paper concludes with a proposal for a comprehensive insurance program that

could harness the benefits of both the public and private sectors.

Contents

1. Introduction ......................................................................................................................... 1

2. The Disaster Insurance Gap .............................................................................................. 2

2.1. Consumer Behavior ..................................................................................................... 3

2.2. Insurer Behavior........................................................................................................... 4

2.3. Regulator Behavior ...................................................................................................... 6

3. The Emergence of Public Private Disaster Insurance Partnerships .............................. 6

4. Roles of the Public and Private Sectors .......................................................................... 10

4.1. Risk Communication ................................................................................................. 10

4.2. Risk Reduction ........................................................................................................... 13

4.3. Risk Transfer .............................................................................................................. 16

5. A Proposed Program ........................................................................................................ 19

6. Conclusion and Suggestions for Future Research ......................................................... 21

6.1. Finer-Scale Risk Communication .............................................................................. 21

6.2. Higher Take-Up of Insurance .................................................................................... 22

6.3. Insurance for Low-Income Households ..................................................................... 22

6.4. New Policy Models .................................................................................................... 23

References .............................................................................................................................. 24

Resources for the Future Kousky and Kunreuther

1

Defining the Roles of the Public and Private Sector in Risk

Communication, Risk Reduction, and Risk Transfer

Carolyn Kousky and Howard Kunreuther

1. Introduction

The cost of natural disasters has been steadily increasing around the world largely

because more properties—and more valuable properties—are being built in risky locations (e.g.,

Benson and Clay 2004; Kousky 2014; Swiss Re Institute 2017). These rising costs have

commensurately increased governments’ liability for disaster losses. Since 2000, the US

government has spent $265 billion on supplemental appropriations for disaster relief (Lindsay

and Murray 2014). Furthermore, climate scientists predict more intense hurricanes, heavier

precipitation events, and more severe heat waves, fires, and droughts in many places across the

globe and the planet warms (e.g., IPCC 2012; Sander et al. 2013).

Insurance is an essential component of household and community resilience for reducing

future losses from floods, earthquakes, and other disasters because it encourages investments in

cost-effective loss reduction measures while facilitating the rebuilding of damaged property and

long-term recovery from disasters through claim payments (e.g., Turnham et al. 2011;

Kunreuther et al. 2013). Yet the same forces that make insurance ever more critical also increase

the challenges for underwriting these risks. Insuring disasters poses a challenge for insurance

companies because of the potential for extreme losses. To meet regulatory and rating agency

requirements, insurers must hold or purchase access to sufficient capital to remain solvent after

an event; this can be costly. The high premiums associated with insuring catastrophic risks may

lead consumers to take their chances by forgoing coverage. The severe loss of capital following a

catastrophic disaster may also lead to “hard” insurance markets, where supply is scarce and

coverage costly. These challenges have prompted various kinds of government intervention in

almost all disaster insurance markets, both in the United States and around the world.

Kousky: [email protected]; Kunreuther: [email protected].

This paper was prepared for the “Improving Disaster Financing: Evaluating Policy Interventions in Disaster

Insurance Markets” workshop held at Resources for the Future on November 29–30, 2016. We would like to thank

our sponsors of this project: the American Academy of Actuaries; the American Risk and Insurance Association;

Risk Management Solutions; the Society of Actuaries; and XL Catlin.

mailto:[email protected]


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This paper synthesizes findings from the dialogue at a workshop hosted by Resources for

the Future and the Wharton Risk Management and Decision Processes Center in November

2016, as well as the six papers prepared for the workshop. The papers evaluated the following

programs: the National Flood Insurance Program (NFIP), the California Earthquake Authority

(CEA), wind pools in the state of Florida, the Terrorism Risk Insurance Program (TRIA), Flood

Re in the UK, as well as all-hazards disaster insurance.

Here, we tease out lessons learned from these programs to suggest ways of improving

public-private partnerships for disaster insurance for households and small businesses in three

interrelated areas: (1) risk communication, (2) risk reduction, and (3) risk transfer. We do not

consider insurance for infrastructure or large commercial entities. We first discuss the challenges

of insuring disasters, and the nature of the decision processes of interested parties in dealing with

low-probability, high-consequence events. With this background, we formulate guiding

principles for a comprehensive insurance program and discuss the limitations of the private

sector in marketing insurance without public sector involvement.

2. The Disaster Insurance Gap

Insurance against disaster losses allows policyholders to finance repair and rebuilding

without having to divert current income or draw down savings. Insurers that give premium

discounts for hazard mitigation encourage those at risk to invest in protective measures prior to a

disaster. Insurance can also reduce disaster assistance from the federal government, which may

be slow to arrive, mismatched to meet immediate needs, and distortionary—that is, it may

generate perverse incentives (Talbot and Barder 2016). For instance, disaster aid may lead those

at risk to underinvest in risk reduction or may skew decisions toward what is funded even if that

is not optimal. Insurance, on the other hand, when priced appropriately, tends to have fewer

incentive problems.

Despite those benefits of insurance, a large disaster insurance gap exists worldwide and

in the United States (Swiss Re Institute 2017). For example, just over 10 percent of homes in

California have earthquake insurance (Marshall 2017). In 100-year floodplains of the United

States, only roughly half of homes are insured against floods, and even fewer outside these areas

carry flood insurance (e.g., Dixon et al. 2006; New York City 2013; Adams 2015). A number of

factors may suppress consumer demand for disaster coverage, impede insurers from supplying

coverage, and/or present regulatory challenges for insurance commissioners.


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Empirical studies guided by research in cognitive psychology and behavioral

decisionmaking over the past 50 years have revealed that individuals and organizations often

make suboptimal decisions about low-probability, high-consequence risks. Decisions about these

risks are often governed by combining intuitive with deliberative thinking. In his thought-

provoking book Thinking, Fast and Slow, Nobel Laureate Daniel Kahneman (2011) summarized

the differences between these two modes of thinking.

Intuitive thinking (System 1) operates automatically and quickly, with little or no effort

and no voluntary control. It is often guided by emotional reactions and simple rules of thumb

acquired by personal experience. Deliberative thinking (System 2) allocates attention to effortful

and intentional mental activities in which individuals evaluate trade-offs, recognize relevant

interdependencies, and consider the need for coordination. Most people make choices by

combining these two modes of thinking.

Intuitive processes work well when people have copious data on the outcomes of

different decisions, and when recent experience is a meaningful guide for future actions. These

processes in general do not work well for low-probability, high-consequence events, however,

because by definition, such events are rare and people have limited or no past experience with

them. For extreme events, individuals exhibit systematic biases, such as being unduly influenced

by a recent disaster, underestimating the future likelihood of a severe loss, or dismissing a risk by

treating it below their threshold level of concern.

2.1. Consumer Behavior

Low-probability, high-consequence events are subject to the availability bias, where the

judged likelihood of an event depends on its salience (Tversky and Kahneman 1973). This is a

principal reason why individuals might purchase insurance only after a disaster but cancel their

policies several years later: if they have not suffered a loss, they now perceive the likelihood of a

disaster as low. An analysis of NFIP policies revealed that the median tenure of flood insurance

was between two and four years, whereas the average length of time in a residence was seven

years (Michel-Kerjan et al. 2012). This behavior can be observed even when homeowners are

required to purchase flood insurance as a condition for obtaining a federally insured mortgage if

banks and financial institutions fail to enforce the requirement over the life of the loan.

Individuals are also myopic, in that they focus on the returns that they are likely to

receive in the next few years rather than over a longer time horizon. When determining whether

to invest in protection to reduce losses to a home or business, people often view the upfront costs


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as much higher than the expected benefits over the next two or three years, and hence they

decide not to undertake these actions. If they focused on the full life of the property, they might

realize that the expected benefits from the mitigation measure exceed the upfront costs; from a

financial perspective, then, the investment would be justified.

Other factors can cause households to be uninsured against disasters. In the United States,

standard homeowners policies exclude losses from floods and earthquakes. Homeowners may

not realize that they have to purchase separate coverage for these risks, or they may know but

decline coverage. Disaster policies may not automatically renew each year and may not be

escrowed as part of mortgage payments, leading some people to drop coverage.

Workshop participants expressed concern that federal disaster aid may create a moral

hazard problem, whereby homeowners and business owners assume the government will provide

them with assistance following damage to their property and so fail to insure. Empirical evidence

on this moral hazard is scant, however. The few papers that have tried to correlate actual disaster

spending with insurance purchases find either a positive relationship (Browne and Hoyt 2000) or

a very small effect (Kousky et al. 2014). This can be explained by the limited disaster money

given to US disaster victims and the requirement that recipients of disaster assistance maintain

insurance policies to be eligible for such aid in the future (Kousky 2016). More research is

needed on the extent to which perceptions of generous postdisaster relief may lead to lower

predisaster insurance purchases.

2.2. Insurer Behavior

Disaster losses can be very severe in some years, that is, losses are “fat tailed” (e.g.,

Malamud and Turcotte 2006; Holmes et al. 2008). In an extreme event, a large number of an

insurance company’s insured portfolio will suffer damage at the same time. To protect against

the possibility of insolvency, insurance companies are required to hold large amounts of capital

and/or secure access to capital through reinsurance or other risk transfer mechanisms; this can be

costly and increase the price of insurance significantly (Kunreuther and Michel-Kerjan 2011).

When disaster insurance is expensive, however, the premiums can be more than property owners

are willing or able to pay (Kousky and Cooke 2012).

It is somewhat surprising that sometimes insurance managers also sometimes exhibit

systematic biases or use simplified decision rules when faced with uncertainty or ambiguous

information regarding low-probability risks. Limited data and limited past experience with


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extreme events may cause insurers to engage in intuitive thinking when determining what

coverage to offer and how much to charge (Cabantous et al. 2011).

Behavior by insurers may follow a “safety-first” model, originally proposed by Roy

(1952) and applied to insurance by James Stone, the insurance commissioner of Massachusetts.

Stone (1973a, 1973b) suggested that an underwriter who wanted to determine the conditions for

a specific risk to be insurable would focus on keeping the probability of insolvency below some

threshold level of concern rather than trying to maximize expected profits. Such an approach,

Stone said, would lead insurers (1) to not charge anything for coverage against a specific risk if

its likelihood were perceived to be very low, and (2) to charge much higher premiums or view

the risk as uninsurable when the likelihood of a disaster and the resulting damage were highly

ambiguous (Hogarth and Kunreuther 1985; Kunreuther and Hogarth 1992). Discussions with

underwriters indicate that this safety-first model still characterizes insurers’ decisionmaking

process.

September 11, 2001, provides an illustration of the behavior. Before the terrorist attacks,

actuaries and underwriters had not determined a price for protection against terrorism coverage

or excluded this coverage from their standard commercial policies. They were essentially

covering this risk for the very modest add-on for unspecified events included in typical property

insurance premiums. Their failure to examine the financial risks associated with terrorism was

surprising, given the attempted bombing of the World Trade Center in 1993, the Oklahoma City

bombing in 1995, and other terrorist attacks throughout the world prior to 2001. Presumably

insurers perceived the likelihood of larger attacks on US soil to be negligible. Following 9/11,

most insurance companies changed course and refused to offer any coverage against terrorism,

considering it an uninsurable risk despite increased buyer demand. The few that did provide

insurance charged extremely high premiums (Michel-Kerjan and Kunreuther 2017).1

1 A few examples stand out. First, Golden Gate Park in San Francisco was unable to obtain terrorism coverage at

any price (Smetters 2004). Second, prior to 9/11, Chicago’s O’Hare Airport had $750 million of terrorism insurance

coverage at an annual premium of $125,000. After 9/11, insurers offered the airport only $150 million of coverage at

an annual premium of $6.9 million (Jaffee and Russell 2003). And third, in early 2002 one insurance broker

negotiated a contract between an industrial firm that was willing to pay $900,000 for $9 million in coverage should a

terrorist attack damage or destroy one of its facilities in the coming year; that is, the insurer considered the

likelihood of damage from a terrorist attack in the next year to be greater than 1 in 10 (Kunreuther et al. 2013).


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2.3. Regulator Behavior

State insurance commissioners and state legislatures authorize the sale of insurance

against different risks, oversee and approve their premiums, and regulate many other aspects of

the private insurance market. Insurance companies have voiced concerns that state regulators

limit their ability to charge prices that reflect the risks they face. It has been observed that US

insurance commissioners tend to weight the affordability and availability of insurance policies

more heavily than solvency considerations (Klein and Wang 2007). Controlling rates to appease

homeowners, however, can make it difficult for firms to operate profitably. For instance, a 2008

examination of cumulative insurer profits by year in Florida revealed that insurance companies

had been in the red since 1992 (Klein 2008). Although the companies made profits in quiet years,

the losses from 1992, 2004, and 2005 more than wiped out all those profits. This led many

insurance companies to scale back operations in Florida and along the Gulf Coast.

After an extreme event, state insurance commissioners often prevent steep price increases

in an attempt to protect consumers. Following Hurricane Andrew (1992), insurance regulators in

Florida prohibited dramatic rate increases and let companies increase prices only gradually over

a decade; the state legislature passed a moratorium on policy cancellations. The Florida

legislature also instituted a three-year moratorium that limited how quickly firms could reduce

their market share in the state (McChristian 2012). Following Hurricane Katrina (2005), Florida

allowed an initial wave of price increases, which were generally highest in coastal areas, but then

began disapproving them in 2006. Other states have taken similar measures. After Katrina, the

Louisiana Department of Insurance prohibited cancellation or nonrenewal of residential dwelling

and commercial property insurance for structures damaged by Hurricane Katrina or Rita (2005)

until 60 days after all repair and reconstruction had been completed (Klein 2008).

Workshop participants commented that companies may feel that the current regulatory

environment makes it challenging for them to develop and test new products designed to appeal

to consumers. It appears that insurance commissioners and insurance companies need to have a

more effective dialogue on how to allow for the pricing of catastrophic risk while protecting

consumers from unfair pricing practices.

3. The Emergence of Public Private Disaster Insurance Partnerships

Private insurers’ concerns about coverage against potentially catastrophic losses has led

to government interventions in these markets around the world. The creation of public sector


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programs has often been spurred by a disaster that exposed the insurance gap or created other

challenges for the private market.

Flood insurance, for example, was offered by the US private sector beginning in 1896.

Following the 1927 Mississippi floods, however, when insurers suffered serious losses, all

insurance companies withdrew coverage of property in highly flood-prone areas because of their

concern with future catastrophic losses as well as challenges with adverse selection (Kunreuther

et al. 1978). It took another disaster, flooding from Hurricane Betsy in 1965, to demonstrate how

few homes were insured against flood, prompting liberal federal disaster relief and widespread

congressional support for creating the NFIP (Knowles and Kunreuther 2014).

Similarly, Hurricane Andrew in 1992 led to the establishment of the Florida Residential

Property and Casualty Joint Underwriting Association (later Florida Citizens), the Northridge

earthquake of 1994 led to the creation of the California Earthquake Authority (CEA), the

terrorist attacks on 9/11 led to the creation of the Terrorism Risk Insurance Program, and

flooding in the United Kingdom, particularly in 1953, led to establishment of the first UK

partnership with the private sector for flood insurance, Flood Re. These quasi- to fully

governmental disaster insurance programs vary substantially in their design, spanning the range

of public-private partnership types. Some provide insurance directly to property owners, while

others offer reinsurance; some offer coverage for a single peril only, while others provide more

comprehensive policies. Take-up rates vary: some have mandatory purchase or offer

requirements, while others do not. Financing arrangements and the public-private shares for

payment of claims vary as well. The programs also differ in the nature and extent of incentives or

regulations for risk reduction and how they make coverage affordable. Table 1 compares the

programs evaluated in this project.2

2 Several other papers and reports have compared countries’ disaster insurance programs (CCS 2008; Medders et al.

2011; Paudel 2012; Atreya et al. 2015; McAneney et al. 2016) but do not draw out specific lessons for the United

States, as we do in this work. We also look beyond just the structure of risk transfer to consider public and private

responsibilities for risk reduction and risk communication as well.


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Table 1. Insurance Program Design Comparison

Coverage

provided

Take-up rates

and mandates Financing

Claims

paying

ability (up to

the given

event) a

Incentives or

mandates for

risk reduction

Affordability

addressed?

National Flood

Insurance

Program (NFIP)

Flood only ~50% in 100-

year

floodplains,

much lower

outside them;

mandatory for

those with

loans in 100-

year

floodplain

Premiums,

debt from

Treasury,

recent

reinsurance

purchase

NFIP has

borrowing

authority

from the

Treasury;

without

borrowing it

can pay

claims up to

a 1/16.7 year

all flood

perils

occurrence

exceedance

probability

(as of 2014)b

Lower

premiums for

elevation and

some

community

measures;

regulations on

development

in 100-year

floodplains

Historically

lower rates

for older

homes

(being

phased out);

continued

discounts for

certain

properties

that face

increased

risk

California

Earthquake

Authority

(CEA)

Residential

earthquake

only

~10%;

mandatory

offer, no

mandatory

purchase

Premiums,

reinsurance,

insurer

contributions

and

assessments,

debt,

accumulated

capital

1/250 year

all perils

occurrence

exceedance

probability

(as of 2014)b

Premium

discounts for

seismic

retrofits on

older homes

and for

mobile homes

reinforced by

earthquake-

resistant

bracing

system

No

Florida Citizens

Property

Insurance

Corporation

Homeowners

policies or

wind-only

policies

Wind

coverage

required by

lenders

Premiums,

reinsurance,

catastrophe

bonds, state

Hurricane

Catastrophe

Fund,

postloss

assessments

on Citizens

and non-

Citizens

policyholders

1/100 year

all perils

occurrence

exceedance

probability

(as of

2013)b; as of

2016, no

postevent

assessments

for 1/100

year event

Premium

discounts for

verified wind-

resistant

features (e.g.,

strengthening

roof-to-wall

connections,

protecting

window

openings and

doors)

No


9

Florida

Hurricane

Catastrophe

Fund

Mandatory

reinsurance

to companies

writing

policies in

Florida

Mandatory

participation

for authorized

property

insurers

Premiums,

reinsurance,

investment

income,

revenue

bonds

N/Ad

None No

Terrorism Risk

Insurance Act

(TRIA)

Reinsurance

for terrorism

losses in

United States

~60%;

mandatory

offer; no

mandatory

purchase

Federal

funds,

surcharges on

commercially

insured

policyholders

Claims

payments

guaranteed

by US

government

for industry

losses up to

$100 billion

None No, but

evidence

rates are a

small

percentage

of total

premiums

Flood Re Reinsurance

for flood

losses in

United

Kingdom

~95% take-up

for primary

coverage;

flood coverage

required for

mortgage and

included in

standard

homeowners

policies

Premiums,

levy on

insurers, ad

hoc payments

from insurers

1/200 year

eventc

None Temporary

premium

subsidies for

high-risk

properties

(shifting to

risk-based

pricing over

20–25 years)

All hazards

Insurance

All natural

hazards

including

flood,

earthquake,

fire, wind,

and hail

Generally

mandatory,

varies by

country

Varies by

country but

may include

premiums,

policy

surcharges,

reinsurance,

government

funds, etc.

Varies by

insurer and

country

Varies and

depends on

whether

pricing is

risk-based

Varies;

uniform

rates or flat

fees in some

countries

(e.g., Spain,

France, New

Zealand)

a This column gives the maximum event, expressed by return interval, for which the program could pay claims.

b These estimates are taken from NFIP (2015).

c Taken from Surminski (2017).

d The FHCF has a statutory limit of up to $17 billion, but this will provide different claims-paying capacity to the

150-plus participating insurers. Without detailed data from each insurance company, it is difficult to determine when

FHCF would exhaust its $17 billion. See Medders and Nicholoson (2017) for more discussion.

Table 1 contains useful lessons. Well-functioning disaster insurance markets for extreme

events—earthquakes, floods, hurricanes, terrorism—require some type of government

intervention. These public sector policies and programs are diverse, often driven in part by a

country’s culture and historical experience. While there does not appear to be one best fits-all

design, some approaches have proven less effective or have more perverse or unintended

consequences than others, as discussed in the following sections. Take-up of disaster insurance is

generally low absent a mandate from either the government or lenders. Very few insurance


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programs charge premiums that fully reflect the risk at a property level because the likelihood

and consequences of future losses are difficult to estimate, the premiums are averaged over large

areas, and/or the premiums are cross-subsidized or discounted for various reasons, such as

affordability concerns or regulatory restrictions on premiums for high-risk properties. Some

actively engage in risk communication and hazard mitigation, while others do less of these

activities. There is large variation in claims paying ability and the financing used by these

programs. At one extreme is the CEA, which has access to capital to pay claims up to a 1-in-250-

year event. At the other extreme is the NFIP, which is already in debt and so has very little

capital to pay claims, although it would presumably have borrowing authority from the Treasury

(it must be increased by Congress).

4. Roles of the Public and Private Sectors

Workshop participants and the authors of the papers in this Special Issue have identified

challenges to insuring against extreme events and offered concrete recommendations for dealing

with them in three related areas: (1) risk communication, (2) risk reduction, and (3) risk transfer.

We consider the comparative advantages of the public and private sectors and how they can

work together effectively in each of these areas.

4.1. Risk Communication

As discussed above, decisionmakers often poorly evaluate low-probability risks,

exhibiting systematic biases. It is thus not surprising that a major challenge is communicating

risk so that those who are exposed to the risk are aware and understand the potential

consequences. Workshop participants agreed that promoting risk understanding and acceptance

of technical risk information was essential and had to be undertaken by both private and public

sectors.

Insurance can play an important role in communicating risk if premiums are transparent

and if the pricing reflects the risk. A premium with a hidden or unexplained cross-subsidy or

discount, however, may lead people to believe they are safer than they actually are. There was a

consensus that property-level risk based pricing would be an improvement over current practices.

Many insurance programs, particularly those where the public sector plays a key role,

have risk communication beyond pricing as an explicit objective. For instance, the website of the


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CEA details earthquake risk for different counties in California and provides information on

what structures may be suited for retrofits.3 The NFIP provides flood risk information through

mailings and online. It also provides flood hazard maps to all participating communities. Since

the maps were created to implement the program and not simply as the best risk communication

tool for local governments, however, they might actually mislead residents in flood-prone areas.

Specifically, the maps define a high risk area as one where the chance of flooding has an annual

probability greater than 1 in 100. This line may lead property owners to believe that if they live

outside this zone they are safe and all areas within it are equally risky (Kousky 2017).

Beyond the insurance programs, there is also a role for public sector information

provision. In the U.S., the federal government already has risk communication efforts, such as

Flood Smart and the Federal Alliance for Safe Homes (FLASH). Flood Smart is the NFIP’s

primary platform for communicating flood risk and insurance information to the public. The

campaign runs messages on radio, television, and in print, but its primary outreach tool is

FloodSmart.gov, a website with detailed information about flood hazards, maps, and insurance

coverage. FLASH, a collaborative disaster safety education organization comprising more than

100 state and federal emergency management agencies, (re)insurers, business, nonprofits, and

others, creates disaster education programs, publishes home safety and insurance guidebooks,

and offers a wide range of resources, including videos, peril maps, and toolkits for homeowners

to make safety improvements on their own. There are also myriad communication activities at

the state and local level. For example, New York City has created the website

http://www.floodhelpny.org to give residents information on flood risk and mitigation options.

Workshop participants agreed that a critical time for information provision is during the

early stage in the home purchase decision. Mandatory hazard disclosure laws at the time property

is sold could ensure that all property owners are informed about disaster risks. Nationally,

potential purchasers of property in 100-year floodplains are required to be informed by the lender

at the time of sale that the property is in a mapped high risk area. Some states have more

expansive disclosure requirements. California, for instance, requires sellers to disclose whether a

property is in a designated flood, wildfire, or seismic area. A study of California’s 1998 flood

hazard disclosure law found that it did have an effect: floodplain properties sold for 4-plus

percent less after the law than before it (Troy and Romm 2004). For such policies to be effective,

3 See https://www.earthquakeauthority.com/earthquake-risk-preparedness.

http://www.floodhelpny.org/


12

disclosure should be made early in the sale process—information disclosed just before the sale is

finalized is unlikely to be heeded, given the buyer’s psychological commitment to the property

(Palm 1981)—and the requirement should be strongly enforced (Godschalk et al. 2000).

Currently, it is rare for property owners to receive any information on how the risk may

change over the coming years or decades. This is most relevant for coastal flood risks, where

sea-level rise and changing storm patterns are likely increasing. The Technical Mapping

Advisory Council, which reviews flood hazard maps for the Federal Emergency Management

Agency (FEMA), has published “Future Conditions,” a report that highlights the importance of

considering how climate change may alter flood risk in the coming years (Technical Mapping

Advisory Council 2015). The New York City website mentioned earlier is also actively

communicating information about changing risk.

The private sector—both for-profit companies and not-for-profit groups focused on risk

management—can complement public sector efforts to improve risk communication. For

example, Temblor is a website (http://temblor.net) and mobile app that provides property-

specific seismic risk data in easy-to-understand formats while also providing information on risk

reduction activities and earthquake insurance (directing users to an agent for a property-specific

insurance quote). As another example, the mission of the Institute for Building and Home Safety,

a nonprofit supported by the insurance and reinsurance industry, is “to conduct objective,

scientific research to identify and promote effective actions that strengthen homes, businesses,

and communities against natural disasters and other causes of loss.”4

Recommendations

Make available to property owners and communities understandable, structure-specific

risk information, perhaps presented as a risk score or metric for each hazard. Disseminate

the information via multiple platforms, including websites, phone-based apps, and print

mailings. Production of such tools will likely require collaboration between the public

and private sectors.

Give homes in risk-prone areas seals of approval or scores based on their susceptibility to

different hazards. This would let potential buyers see how well the structure is protected

against future disasters. Property inspections should be conducted by independent,

4 https://disastersafety.org/about/

http://temblor.net/


13

certified individuals and supported by real estate agents, financial institutions, and

communities.

Develop community maps delineating current and future flood risk.

Coordinate the various government risk communication efforts across agencies and scales

of government, to promote synergies and avoid duplication of effort.

4.2. Risk Reduction

In the United States it appears that cost-effective mitigation measures are not undertaken

by many property owners and renters in hazard-prone areas. For instance, only an estimated 10

percent of earthquake- and flood-prone households have implemented mitigation measures.

Reasons for the lack of mitigation may be that property owners underestimate both the risk of a

future disaster and the potential benefits of mitigation, and others may not have access to capital

to cover the up-front costs (Kunreuther et al. 2013).

Misaligned incentives for risk reduction may suppress mitigation investments. Many

workshop participants observed that local governments reap the benefits of economic

development through increased tax revenue but bear none of the costs when a disaster occurs.

Hence they lack economic incentives to adopt strong building codes or limit development in the

highest-risk areas. Similarly, there was concern that federal assistance under the Stafford Act

may make local governments less interested in mitigation: federal disaster relief covers at least

75 percent of the cost to replace or repair damaged public buildings and infrastructure. Empirical

research on any incentive effects from federal assistance to local goverments is, however,

lacking.

Insurance and mitigation may be viewed as substitutes if the mitigation measures reduce

risks enough that property owners can comfortably self-insure. But for most cases, mitigation

can be more appropriately viewed as a complement to insurance if premiums reflect risk since it

lowers potential losses and hence insurance claims. This effect could motivate partnerships

involving private insurers, public or quasi-public insurers, and the government in encouraging

risk reduction.

Charging risk-based prices for insurance and providing long-term home improvement

loans for cost-effective hazard risk reduction could overcome consumers’ tendency to be myopic

and not look beyond a short time horizon. If the upfront cost of the mitigation measure is spread

over a long period, such as the term of the mortgage, and the annual insurance premium is

reduced, investing in mitigation could be advantageous to the property owner (Kunreuther 2008).


14

The Small Business Administration already offers loans for disaster victims to include hazard

mitigation in their rebuilding, although very few households take advantage of this program.

FEMA has produced outreach materials to inform homeowners that if a rebuilding loan includes

the cost of elevation, it can often be cheaper to elevate several feet above the minimum due to

the much lower flood insurance premium they receive for such elevation (FEMA 2013). Xian et

al. (2017) has determined the optimal elevation based on estimates of the NFIP risk-based

insurance premium coupled with a long-term loan at different interest rates and payback periods.

Several insurance programs and companies offer premium reductions for certain

mitigation measures. For example, the NFIP offers substantially lower rates when homes are

elevated above the base flood elevation (see Kousky et al. 2016). The CEA now offers premium

discounts up to 20 percent for new, safer construction (Marshall 2017). In addition, some

states—including Alabama, California, Florida, Louisiana, Maryland, Mississippi, New York,

South Carolina, and Texas—require companies to offer premium discounts for certain hazard

mitigation measures, or they have state insurance programs that offer such discounts

(Multihazard Mitigation Council 2015; OMB 2016). It is unclear, however, whether these

programs have encouraged homeowners to invest in new hazard mitigation measures or simply

rewarded homeowners who have already done so.

Florida provides a cautionary tale on the potential problems with state-mandated

premium discounts. In 2003, it required insurance companies to provide discounts for certain

mitigation options. Unfortunately, the way the state enacted this requirement was such that it

forced companies to provide premium discounts that were unjustified and not matched to claims

payments (for more detail, see Medders and Nicholson 2017). Moreover, accountability and

oversight were insufficient. In the end, more than half of inspected homes obtained premium

credits without undertaking any mitigation (Medders et al. 2014), and these financially unsound

credits may have prompted insurers to leave the state or damaged firms’ financial positions

(Florida Commission on Hurricane Loss Methodology 2010).

Governmental disaster insurance programs can have unique opportunities to promote or

fund hazard mitigation. Risk reduction is an explicit goal of the NFIP, with FEMA offering

grants to encourage homeowners to mitigate properties that flood repeatedly. Reducing losses

through cost-effective mitigation is critical to reducing future claims, since unlike a private

insurer, the program cannot refuse coverage to any property in a participating community. The

CEA has two grant programs for mitigating properties at greatest risk of earthquake damage.

One is for risky properties that have held a CEA policy for three or more years. A qualifying


15

homeowner who braces and bolts the insured structure receives a $3,000 grant to offset the costs,

as well as a 20 percent reduction on CEA premiums.5

The federal government has small amounts of grant dollars available for supporting risk

reduction projects during the pre-disaster period. One example is FEMA’s Pre-Disaster

Mitigation grant program; the Corps of Engineers also invests in risk reduction prior to disaster

events. For flooding, a recent analysis of federal risk reduction spending—which includes

programs in FEMA, the Corps, and the Department of Housing and Urban Development, among

a few others—finds that more than 90 percent of the funding is tied to a presidential disaster

declaration post-disaster and limited to the affected community; very little funding is available

pre-disaster (Kousky and Shabman 2017).

Local governments can reduce risk through well-enforced building codes and land-use

regulations. The NFIP has a unique lever to influence these decisions, since flood insurance is

available to a community only if the local government adopts floodplain regulations, including

that all new construction in the 100-year floodplain to be built at or above the base flood

elevation. Beyond this minimum requirement, the NFIP tries to encourage voluntary risk

reduction by local governments through the Community Rating System. If a community takes

steps to lower its flood risk, all property owners receive discounted flood insurance premiums.

Flood Re, the flood insurance program in the United Kingdom, has not yet taken steps to

encourage investment in risk reduction measures, a potentially missed opportunity (Surminsky

2017).

Recommendations

Expand federal and state funding for predisaster hazard mitigation, particularly for the

riskiest properties, such as those that experience repetitive flooding.

Examine how insurance premium reductions could create incentives for new mitigation

investments, perhaps in combination with low-interest loans.

Promote funding and financing that are underutilized, such as postdisaster Small Business

Administration loans for hazard mitigation.

Convene an expert group to investigate better ways of incorporating the full costs of

insuring a structure over its life into initial decisions of where and how to build.

5 For more information, see the program website: https://www.ceabracebolt.com/.


16

4.3. Risk Transfer

Risk transfer for disasters can be costly, for the reasons discussed in Section 2. We begin

with the proposition that the private market should insure and reinsure disaster risks to the extent

it can, recognizing that the public sector will need to play three complementary roles to facilitate

equitable and efficient transfer of risk: (1) making disaster insurance affordable for low-income

households, (2) providing public reinsurance against catastrophic losses that are beyond the

capabilities of reinsurers and other risk transfer instruments, and (3) mandating insurance

coverage, if widespread take-up rates is a policy objective.6

The cost of disaster insurance is often high, and the cost burden of flood insurance

premiums on low-income households has emerged as a policy concern (National Research

Council 2015). If disaster coverage is deemed critical for such households, help should come

through an explicit federal assistance program rather than through a cross-subsidy that distorts

risk signals and is viewed as inequitable by those who are charged higher premiums to cover the

cross-subsidy.

Such pricing distortions have been used in several of the programs evaluated, including

the NFIP and Florida Citizens. In the NFIP, lower premiums were provided, not based on

household income or wealth, but on the age of the structure: older homes were given discounted

rates, which rendered the program unable to finance catastrophic losses (Kousky 2017). Due to

legislation in 2012 and 2014, these are now being phased out. Beginning in 2005, Florida

Citizens Property Insurance Corporation, a nonprofit, tax-exempt government entity, effectively

froze premiums that were highly subsidized; the private sector could not compete, and Citizens

became the largest insurance provider in the state. Private insurers’ surplus plummeted, and

many left the state (Medders and Nicholoson 2017). The CEA, on the other hand, has not

discounted premiums in any manner that would threaten the financial standing of the program,

but as a result, take-up rates are very low, hovering around 10 percent (Marshall 2017). To the

extent higher premiums deter the purchase of insurance, risk based pricing may discourage some

property owners from purchasing coverage voluntarily.

6 The public sector must also, of course, continue to play a role in consumer protection regulations. In the United

States, state-level regulators protect the consumer by requiring that insurers have sufficient capital and surplus to

pay claims following a severe disaster. These capital requirements are designed to minimize insolvency risk.

Regulators also approve insurance pricing to protect the consumer from unfair premiums.


17

For disaster risks with a very long tail of the loss distribution and risks that are difficult to

model, states and the federal government can cover extreme losses above a large threshold. This

is the case today with terrorism coverage. After 9/11, as discussed above, insurers refused to

offer terrorism coverage or did so at exorbitant prices, and in response Congress passed the

Terrorism Risk Insurance Act (TRIA), which requires primary insurance companies to offer

terrorism coverage in exchange for the federal government’s covering a portion of catastrophic

losses. This is not a complete federal backstop of losses above some threshold, since the federal

government can recoup its payments ex post through commercial policyholder assessments. The

arrangement has made terrorism coverage widely available and affordable for commercial

properties (Michel-Kerjan and Kunreuther 2017). In contrast, a federal backstop was never

explicitly guaranteed for the NFIP, and now the program carries a debt that it will never be able

to repay.

The Florida Hurricane Catastrophe Fund (FHCF), an example of US state reinsurance,

was created in 1993 to provide more capacity for private insurers to offer coverage in the state.

Florida Citizens and private insurers are required to purchase protection from the FHCF. Surplus

in the FHCF can accumulate tax-free. In the event of a large disaster, it can issue bonds to pay

claims and then repay this debt through assessments on policyholders in most lines of property

casualty insurance. Although FHCF pricing is required to be actuarial, it is still below the costs

of private sector reinsurance, since it is tax-exempt and does not need to include the risk and

profit loads or marketing costs and expenses that private reinsurers incorporate in their pricing

(Medders and Nicholoson 2017).

In other countries, the government covers losses above a high threshold, either as a

backstop or as reinsurance. For example, in Spain, where “extraordinary risk” insurance is a

mandatory component of property, life, and personal accident policies, the state-run Consorcio

de Comepensacion de Seguros is responsible for insuring against natural hazards and social-

political perils and operates with an unlimited government guarantee. In France, insurers are

required to provide natural catastrophe coverage as part of “physical damage” contracts and may

transfer those risks to the state-owned reinsurer, Caisse Centrale de Réassurance, at a subsidized

cost. It is secured by a government backstop, but payouts are contingent on an official

declaration of a natural catastrophe. In New Zealand, the government’s Earthquake Commission

provides natural disaster protection automatically to homeowners who insure against fire. The

program administers and pays claims from the state’s natural disaster fund, which is backed by

an unlimited government guarantee.


18

Another approach to helping the private sector manage catastrophic losses is to set up a

separate program for the riskiest properties, as Flood Re has done in the United Kingdom

(Surminski 2017). Insurers can cede the riskiest properties to the Flood Re pool at a discounted

price, paid for by a levy on all insurers according to their home insurance market share. Because

the private insurance company’s liability for these properties is reduced, it can write coverage for

the remaining properties in flood-prone areas of the country. In this model, as with the Florida

programs, the cost is distributed over a wider base of policyholders, not just those who have

suffered a loss.

Similarly, residual market mechanisms in the United States were designed to provide

coverage for those unable to find a policy in the voluntary market. The Insurance Information

Institute has found that exposure in beach and wind pools has been growing, suggesting these are

not markets of last resort but often primary markets for wind coverage in hurricane-prone areas

(Hartwig and Wilkinson 2014). In Florida, Citizens explicitly chose to offer lower-cost policies

and became the largest insurer in the state (Medders and Nicholoson 2017). More recently, it has

been shedding policies to better manage exposure.

The benefits of widespread take-up of disaster coverage include reduced rebuilding time,

faster resumption of normal economic activity, the decreased need for federal relief, and

enhanced resilience. If increasing take-up is a policy goal, it may be necessary to require

homeowners to purchase disaster insurance. Substantial evidence indicates that households do

not voluntarily insure against earthquakes and floods, and lenders in the United States do not

require insurance against earthquake risk and only require flood when mandated by law. As

pointed out in Section 2, many homeowners in flood-prone areas who are required by the NFIP

to have coverage are uninsured today. Bundling flood and earthquake insurance into the

homeowners coverage that banks require as a condition for a mortgage would dramatically

increase take-up rates (Kunreuther 2017). Flood coverage is much more widespread in the

United Kingdom, where it is a part of homeowners insurance and required by lenders (Surminski

2017).

Recommendations

Develop a federal assistance program for low-income households so that they can afford

disaster coverage. This should be paid for by general tax dollars and not through cross-

subsidies in insurance pricing.

Determine whether government backstops or reinsurance against catastrophic losses not

covered by private reinsurance or other risk transfer mechanisms, such as catastrophe


19

bonds, could strengthen and improve the functioning of the primary insurance market.

The study should identify the level at which government support is made available and

define the structure and process for receiving that support.

Analyze when and how risky properties could be ceded to a government residual market

and how those risks would be financed.

Promote better relationships between state regulators and insurance companies on

disaster lines and innovation in product offerings for disaster lines.

5. A Proposed Program

We conclude with a proposal for a comprehensive program that capitalizes on the

strengths of the public and private sectors while requiring property owners to absorb some of the

risk associated with disasters so that they have incentive to undertake mitigation measures. We

base this proposal on several guiding principles:

Premiums should reflect risk, with information on the hazards clearly communicated to

prospective policyholders.

Cost-effective mitigation measures should be encouraged through insurance premium

reductions and long-term loans that spread the upfront costs over time.

Affordability of insurance for low-income residents should be addressed through public

sector assistance, not subsidized insurance premiums.

Catastrophic losses that cannot be covered by private reinsurance or other risk transfer

instruments should be backstopped by the public sector.

The public sector should provide incentives, information, and some funding for

investments in risk reduction.

All natural disasters should be covered in a single private insurance policy to reduce the

variance in losses and satisfy homeowners’ desire to be covered against all hazards.

We propose a system of layering of disaster losses as shown in Figure 1. The blue boxes

show schematically how the lowers would function; the size is not necessarily proportional to the

amount of coverage in each layer. This layering idea is not new, and it has many appealing

features, such as providing more appropriate economic incentives, enhancing the involvement of

the private sector, and better meeting the financial needs of those at risk from future disasters


20

(e.g., Litan 2006). We note, however, that the layers of risk transfer need to be supported by

public and private sector activity centered on risk communication and risk reduction.

Figure 1. Layering Disaster Losses

The property owner would be responsible for the first layer of losses through a

deductible, which creates an incentive to reduce future losses by undertaking mitigation

measures while reducing moral hazard. Property owners could choose higher deductibles that

would lower their insurance premiums if they were able to self-insure a higher portion of losses.

Higher deductibles might be supported by tax-exempt disaster savings accounts, which property

owners could tap to cover losses.

The second layer of losses would be transferred to an insurer through a homeowners

policy that included all natural perils, with premiums reflecting risk. Banks and financial

institutions would require this coverage as a condition for a mortgage.7 An all-hazards policy has

numerous benefits for the property owner. As the National Association of Insurance

Commissioners has observed, having to purchase multiple policies is inefficient and confusing,

and it delays claims settlements because the cause of the losses from hurricanes—wind or

water—must first be determined (NAIC 2009). Following Hurricane Katrina, insurers spent

considerable time and money fighting lawsuits from policyholders who contended that damage

to their homes was due to wind, in which case the standard homeowners policy would cover the

losses, rather than inundation. An all-hazards policy would avoid this problem (Kunreuther

7 The NAIC has suggested an insurance mandate in highest-risk zones for property owners with federally backed

mortgages. This is similar to the current flood insurance requirement by the NFIP but includes all natural disasters

(NAIC 2009).


21

2017). Financial assistance for low-income homeowners would be provided by the government

in form of tax credits or vouchers based on specified criteria for household income or house

value. The tax credit or voucher could also cover the cost of a loan to enable the property owner

to invest in cost-effective mitigation measures (Kousky and Kunreuther 2014).

The next layer of losses would be covered through private reinsurance or other forms of

risk transfer, such as catastrophe bonds purchased by the insurance company. The highest layer

of losses would be covered by the public sector. Although neither has been tested yet with a

catastrophic loss event, the experience of both Flood Re and TRIA suggests that if the

government can cover the riskiest properties, or cover catastrophic losses, the private market

could profitably offer disaster insurance for the remaining losses above the deductible. Coverage

at the state or federal level could entail ex ante premiums or ex post assessments to recoup some

or all of the public sector expenditures. The attachment point for state or federal payments would

need to be carefully determined. It should not be too low, since the private market should be

encouraged to bear as much risk as possible, but it also needs to make private firms feel

comfortable about bearing the remaining risk. This would require a detailed market evaluation.

As shown in Figure 1, both the public and private sectors would need to also engage in

supporting activities, such as risk communication, adoption and enforcement of building codes,

and limitations on future development through restrictive zoning and other land-use regulations.

6. Conclusion and Suggestions for Future Research

Disasters are challenging to insure, and the price of coverage is often high. In response,

policymakers around the world have devised a variety of quasi-public and fully public disaster

insurance schemes. In this paper, we have teased out some guidelines for how the public and

private sector can work together to move toward a system in which comprehensive and

affordable coverage is provided for those at risk. That said, it is clear that more detailed research

and investigation are needed to inform reform efforts of the current systems. In addition, new

policies may be required. We highlight several in this concluding section.

6.1. Finer-Scale Risk Communication

Participants in the workshop agreed that better information on the specific risks at a given

property could encourage investments in risk reduction and promote the purchase and retention

of disaster insurance. Because prices send a power signal about risk, fine-grained insurance

pricing could also improve risk understanding. Communication efforts presuppose better


22

mapping and modeling. For flood, this means investment in more data and application of

advanced modeling techniques. Where data are not available or cost-effective, lower-cost

options, need to be explored. All approaches require funding, however, and thus Congress should

appropriate funds for continued improvements in hazard mapping. Once better maps are

available, researchers in risk communication should investigate the most effective ways of

communicating the results to residents.

6.2. Higher Take-Up of Insurance

Various factors can explain why so many people at risk have no disaster insurance and

fail to invest in hazard mitigation: homeowners may lack information on the risk, dismiss it as

negligible, be myopic, lack the necessary capital, regard the transaction costs as too high, or

respond to perverse incentives. Field research is needed to untangle which contributing factors

are most important and whether policy changes could help counter the tendency to underinvest in

insurance and mitigation.

One of the biggest challenges is to convince homeowners that not incurring losses from a

disaster does not make the purchase of insurance a waste of money or justify canceling the

policy. It is extremely difficult to get the message across that people should celebrate not having

collected on their insurance policy this year, and that a disaster could still occur next year. Future

empirical and experimental research could determine the effectiveness of rebates for those who

have not suffered a loss coupled with messages such as “the best return on an insurance policy is

no return at all.”

6.3. Insurance for Low-Income Households

One part of closing the disaster insurance gap is making sure that all those living in risky

areas can afford disaster insurance. Workshop participants suggested that instead of using cross-

subsidies in pricing, Congress create an explicit program to provide assistance to households in

need, coupled with a mitigation program. This approach would reduce both the losses incurred

by low-income residents and the costs of risk transfer. There remain several unanswered

questions, however: how much assistance would be needed, what the scope of the program

would be, and what types of mitigation could be offered, among others. A good example of the

type of studies needed was recently completed by RAND (Dixon et al. 2017).


23

6.4. New Policy Models

This paper has proposed several roles for the public sector in improving insurance of

disasters, and an even broader array of policies have been proposed in scholarly work on this

topic. More research is needed on comparing and evaluating these alternatives. For example,

would a residual pool model or a federal reinsurance model be preferable—and on what

grounds—to the current federal program of direct writing of flood coverage? Such work first

requires developing a consensus on the public policy goals that should guide program

development.


24

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